New Obama Tax Increases Are Bad Enough for Wealthy, but under Democratic Sponsored House Bills, Estate Planning Will Be Turned Upside Down

Looks like financial advisors catering to the affluent will have a new disaster to talk about: Obama’s tax hikes and closing of personal exemptions and itemized deductions. Oh, that and the nearly $4 trillion fiscal year in government spending (or about 28 percent of U.S. GDP), which will have repercussion on personal wealth way down the road.

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Looks like financial advisors catering to the affluent will have a new disaster to talk about: Obama’s tax hikes and closing of personal exemptions and itemized deductions. Oh, that and the nearly $4 trillion fiscal year in government spending (or about 28 percent of U.S. GDP), which will have repercussion on personal wealth way down the road. The proposed budget the Federal Government intends to reorder the American economy, from college education grants to corporate profits made overseas to taxes on carbon-based energy. Even the cherished mortgage deduction is under the knife for wealthy Americans. So long EGTRAA!

The web is abuzz with commentary on Obama’s budget, released yesterday. You can read about that the anti view and the pro view. What is also remarkable: Obama’s plan would use the tax credits to pay people who pay no federal taxes (other than Social Security and FICA).

But what is really scary are Democratic bills being proposed in the House of Representatives, says Roy M. Adams, an estate law expert at Adams & Matz LLP, associated with Constantine Cannon LLP. (Adams is also chair of Trusts & Estates magazine’s editorial advisory board. Trusts & Estates is a sister publication to Registered Rep.) Under HR 436, sponsored by Earl Pomeroy (D-ND), Congress would eliminate the $3.5 million exclusion for estate (death) taxes for estates, but, and perhaps even worse, it would also eliminate the “minority and marketability discounts,” a 50-year-old IRS ruling. “That’s the heart of most people’s tax planning,” says Roy Adams. “It’s vital to estate planning.”

(Adams allows that HR 436 would also eliminate the “carry over basis rules,” which, Adams says, “is a good thing.”)

The “discounting” mechanism in tax law basically states that if you own a minority or illiquid stake in a business (everything from a farm to real estate to a McDonald’s franchise), the IRS says in Rule 59-60 (scroll down to middle on link) that the stake in the business is worth what a buyer would pay for it; in short, the value of a holding was based on its fair market value. That usually meant discounting the value of a person’s interest if the holding is illiquid or a minority stake. For example, let’s say you own one-third of a vacation rental property that is worth $1 million. Since you are a minority shareholder with only 33 percent interest in the property, you are “hostage” to the will of the majority shareholders. You can’t vote, and win, to do anything to the business by yourself (such as increasing dividend payouts, investing in the business, selling the property and etc.). As a result, the IRS ruled all those years ago that your $333,000 stake in the property was really worth less than that to a buyer on the open market because of that minority stake. (Adams says buyers sometimes the discount is quite wide, about 35 percent lower than the stated market value of the enterprise as a whole.) Under HR 436, sponsored by Pomeroy, the government will tax you based on the full amount of your stake in the entity, liquidity or minority status be damned. In short, your client’s tax bill will no longer be based on the actual market value of his stake. So, if your client dies, the tax bill will be based on the full $330,000 instead of its market value of around $215,000 (in this overly simplified example, anyway). (To be sure, some financial advisors say the discount amount is open to abuse, since a business interests may be chopped up among family members without any real reduction in control.)

“You can’t sell it for that [full amount],” says Adams, but “your [estate] will be taxed on that. It’s a disaster.”

And the other big threat to the accumulated wealth of affluent Americans? The bill would also increase the estate tax to 45 percent and eliminate the exclusion of the first $3.5 million. Put another way, if your client has over $1 million, the estate will owe tax based on 45 percent on of the entire estate. Currently, the first $3.5 million is excluded. It goes to zero in 2010, but reverts back to $1 million in 2011. For more on potential estate planning changes, see this New York Times article.

But, wait, there is more. There is talk in the House Ways & Means Committee that represents “the real terror,” Adams says. In that committee, Democrats are discussing increasing taxes on couples making $200,000 and filing jointly; that tax rate would jump to 36 percent from 33 percent. The highest tax rate would jump to 39.6 percent from 35 percent, as it would under Obama’s budget. And, like Obama, the House Democrats would like to raise capital gains taxes to 20 percent from 15 percent.

What this means, says Adams, is that if you have clients who have “multiple millions” of dollars, annual taxes will likely increase by $1 million.

The effect of Obama’s budget is highly negative on wealthy Americans, but Pomeroy’s bill, Adams says, is “hell on wheels.”

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Moreover, Obama’s claim that a partisan stalemate is to blame for impending tax hikes obscures the fact that when Democrats controlled every lever of power in Washington, they did nothing to cancel the tax hikes, instead focusing almost exclusively on a health care bill that piled even more taxes on the middle class. -reputationadvocate.com

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